Showing papers by "Robert M. Solow published in 2018"

A theory is a sometime thing

Abstract: Milton Friedman’s famous presidential address of 1968 is nominally about the uses and conduct of monetary policy. But there is also a fairly plain, broader subtext. It aims to undermine the eclectic American Keynesianism of the 1950s and 1960s, the habits of thought to which Joan Robinson attached the (unintentionally) complimentary label of ‘bastard’ Keynesianism. I will only say a little about what that was. In fact, the adjective ‘eclectic’ is meant to remind you that it was not a tight axiomatic doctrine but rather the collection of ideas in terms of which people like James Tobin, Arthur Okun, Paul Samuelson and others (including me) discussed macroeconomic events and policies. These ideas usually included a distinction between aggregate demand and aggregate supply (or ‘potential’) along with the understanding that equilibrating mechanisms were weak enough and slow enough that persistent gaps could exist between them. When demand fell short of potential, some version of the IS–LM model was standard, to which extensions and refinements could be added when needed. In due course one or another variant of the Phillips curve became part of the standard apparatus. A systematic allowance for supply shocks and their consequences came later and was duly absorbed. In the section on ‘What monetary policy cannot do,’ Friedman goes after two of these lines of thought. His first claim is that the central bank, the Fed, cannot ‘peg’ the real interest rate. (The meaning of ‘peg’ will turn out to be important.) It has to be the real interest rate if it is to affect investment and other spending. The point here is to undermine the standard LM curve. Nowadays it is common practice to replace the old LM curve with given M by a central-bank reaction function that specifies a real policy rate as a function of the level of economic activity. In this setting Friedman’s claim is that there can be no such reaction function. The Fed can peg the nominal federal funds rate, but not the real rate. The basic reason is that the Fed controls a nominal variable, the size of its own balance sheet, and it can use this control to determine another nominal quantity but not a real one. (Eclectic American Keynesians took it more or less for granted that the woods were full of rigidities, lags, and irrationalities, so that nominal events could easily have real consequences.) But the essence of Friedman’s argument is explained more concretely. Suppose the Fed tries to achieve a lower real interest rate (starting from some initial equilibrium position); open-market purchases of securities will raise their price and lower their nominal yield. The price level does not respond instantaneously, however, so the real rate of interest also falls. As Friedman says, this is only the beginning of the process, not the end. Lower interest rates and higher cash balances will stimulate investment and perhaps other spending. (This was presumably the Fed’s purpose in the first place.) Higher spending will increase the demand for credit, raise prices and thus reduce real cash balances, and so on. After a brief discussion, Friedman comes to the point I want to emphasize. ‘These ... effects will reverse the initial downward pressure on interest rates fairly promptly, say, in something less than a year. Together Review of Keynesian Economics, Vol. 6 No. 4, Winter 2018, pp. 421–424